Chapter 38

A share issue is a sale of shares, the proceeds of which go to the company and thus indirectly to all shareholders who will therefore share future cash flows.

In the theory of markets in equilibrium, the cost of a capital increase is equal to the cost of equity given the valuation of the shares. This is neither the dividend yield nor the earnings yield (reverse of P/E). It is a forward-looking cost and one to which there is no firm commit- ment on the company’s part. (Ex post it may be quite different: exorbitantly high or actually negative.) Value is created for current shareholders if the capital increase captures the value creation stemming from the new funds.

A capital increase tends to benefit lenders to the detriment of shareholders insofar as the market re-rates the company’s debt to reflect the reduced risk of its share issue. A capital increase tends to favour current shareholders over new, via a transfer of value, if the rate of return on new investments is correctly anticipated. The a priori negative signal that any capital increase sends – namely, that the shares are overvalued – has to be countered (sig- nalling theory). A capital increase entails a temporary reduction in informational asymmetry (agency theory).

The reduction in equity rights of a shareholder that neither puts in nor takes out funds on the occasion of a capital increase is called real dilution. In the case of a rights issue, real dilution is different from apparent or overall dilution.

This dilution of power and control is to be distinguished from the dilution (or its opposite) in the company’s financial parameters in the short term. Any share issue increases EPS when the reciprocal of P/E is less than the after-tax rate of return on reinvested funds. Book value per share is diluted for current shareholders if the company’s market capitalisation is less than its book value.